Intrinsic Value of Money

What is the distinction between intrinsic value and market value? Lately, people don't seem to be recognizing any distinction at all, or insisting that there's no such thing as intrinsic value, only market value. Market value[1] is the price at which an asset trades at competitive open auction, e.g. on an exchange or between competitive retail locations. Market value includes such factors as supply and demand and sentiment. Market value is the aggregate belief of market participants of what an asset is worth in fair trade at the present time. Intrinsic value, on the other hand, is the factually-based objective worth of an asset, absent extenuating circumstances such as shortages, fads, growth expectations, bubbles, etc.

Still, even some definitions on various investing websites such as fool.com list intrinsic value as a "belief" held by an investor[5]. That is more understandable when considering the intrinic value of equities, however, which may depend on factors such as discounted cash flow and P/E ratio, which are open to interpretation, and because the supply of company stock is usually static until the company's board of directors decides to issue more stock. Insofar as stock investing is partly a matter of predicting the future, intrinsic value of equities may be a matter of justified belief about fundamental facts.

But when it comes to a commodity, the intrinsic value is more cut and dry. The "intrinsic value" is equivalent to the all-in cost of producing one additional unit[2]. E.g. the intrinsic value of a bottle of Coca-Cola is the all-in cost of the sugary liquid, plastic bottle, labeling, marketing, labor, equipment purchases and repairs, delivery trucks, etc. Adam Smith referred to this as the prime cost of a commodity[3][4]. You might estimate such a figure by dividing the number of bottles the Coca-Cola company produces in a year by the total expenses of the company in that year. Of course it's not that easy since Coca-Cola produces more than just bottles of one size, but also syrup, other beverages, and other foodstuffs. But the point is that there exists a figure for the break-even cost of a bottle of Coke which is not open to interpretation. It is literally what it costs to produce the next bottle. Every bottle that is sold for more than that represents a profit to the company. Anything sold for less is a loss. It would be hard to argue that anything has less embodied value than what it costs to produce it. Any given individual could of course deign a particular good of less value to himself than it would cost to produce it, and therefore choose not to procure it, but for anyone who does desire a good, he must be prepared to at least cover the costs of its production.

If you were able to obtain a bottle of Coke for less than its intrinsic value or prime cost, you would have realized an objective net gain in wealth in the transaction. Everyone who buys a bottle of Coke realizes a subjective gain, in that they value the consumption of Coca-Cola more than the $1.50 or whatever they paid. But to buy a bottle for less than the intrinsic value -- i.e. what it costs to produce one -- represents not just a great buy, but an investment. You could theoretically resell it at a price which undercuts the manufacturer, since their wholesale price must include the intrinsic value plus a profit margin. And the retail price includes the wholesale price plus a profit margin for the retailer. The market value is usually something close to the retail price, perhaps somewhat less when you consider promotions and sales, but nearly the same. So the market value of an asset -- what someone will pay -- is not the same as the intrinsic value -- what it actually costs to produce it.

Arbitrage and investing comes into play when the market value of something strays wildly from its intrinsic value. Some people will recognize that the market is temporarily out of whack and make a profit from anticipating a reversion to the mean. One way to do so is to "sell short" the asset in question[6]. For example, if there were, say, a shortage in pencils causing their prices to far exceed their cost of production, an entrepreneur might borrow a stock of pencils now, sell them at market prices, invest the proceeds into a pencil factory, and then return the borrowed pencils from the production of new ones. Another way is to "buy long" an undervalued asset (this is called value investing)[7]. For example, the pencil factory produces a glut of pencils far exceeding demand, crashing the prices below the cost of production. An investor might see this opportunity to buy up the stock of pencils at a market price of below the intrinsic value, wait for the factory to cut back production or go out of business, and then sell them when pencil prices return to a level above intrinsic value. If there were no intrinsic value, but only a market value (this is basically, especially in regard to equities, the "efficient market hypothesis")[8], such investing would not even be possible.

So besides the role that intrinsic value has in directing production and stabilizing market prices, why is this important? One reason is in deciding what we consider to be money. Since the time of Aristotle, money has been defined as something which functions as a medium of exchange, unit of account, store of value, and standard of deferred payment[9]. The main distinction between money and currency is that currency does not have to be a store of value and standard of deferred payment. Money has intrinsic value; currency need not and generally does not have any intrinsic value. In particular, fiat currency -- such as U.S. Federal Reserve Notes (a.k.a. Dollars), Euros, and Bitcoins -- have no intrinsic value, by definition. Fiat literally means to declare "it shall be" with no rational intrinsic basis, but just the desire of legal authorities that it be so.[10] The cost to produce another dollar, euro, or bitcoin is virtually zero. Paper notes may have an intrinsic value similar to toilet paper, but most fiat currency is simply digits in a computer, not even notes. E.g., the Federal Reserve bailed out banks in 2008 by creating digital entries in their computer system "valued" at trillions of dollars[11]. As such, fiat currencies will not retain their market value and any deferred payments denominated in them will be less valuable when paid than when incurred.

Fiat currencies do have a market value, either because of legal tender laws, fraud, or bubble, but it is mostly predicated on the greater fool theory[12]. This is the idea that you will accept something as valuable not because you believe in its intrinsic worth, but because you assume that you'll be able to pawn it off to a "greater fool" for the same or higher price in the future. Legal tender laws essentially assure the market that the government will always be the "greater fool" in that you can at least pay your taxes in the currency granted legal tender status[13].

Fraud has long been the method of giving market value to fiat currencies by pretending that there is some intrinsic value when there isn't. E.g. prior to the Federal Reserve, when banks printed their own notes, they routinely printed more notes than they had reserves to back them up -- this is called a fractional reserve banking system -- which resulted in "bank runs" when people wised up[14]. The Federal Reserve then nationalized this process by establishing a "gold standard" convertibility system wherein an FRN (Dollar) was fully exchangeable for 1/20th oz of gold. Except that they also operated on a fractional reserve system, and so in 1933, they debased the currency to 1/35th oz of gold[15], and in 1971 removed all convertibility whatsoever[16]. So essentially the Federal Reserve operated on fraud from 1913 til 1971 by promising and then reneging on convertibility to gold; and then they operated on legal tender laws and simply ubiquity of "greater fools" in the general market (including through Petrodollar Hegemony[17]) to continue it thereafter.

Likewise, so-called crypto-currencies such as Bitcoin operate partly on fraud and mostly as a bubble. Most people simply don't understand them and so take it on faith when others tell them they are valuable, usually by citing the usefulness or security of the currency, or by pointing out that it's not issued by a government. But none of these things imbues bits with intrinsic value. It costs nothing to produce a bitcoin and any effort required to do so is arbitrarily imposed[18]. As evidence of this, competing crypto-currencies have been created, including Litecoin and Peercoin. In fact, as of this writing, over 144 different cryptocurrencies are being circulated[19]. Since it costs nothing to create them, scam artists are able to pump-and-dump a crypto-currency as though it were valuable. But without legal tender laws, there is no guarantee of any greater fool, and so they operate mostly as bubbles like Ponzi schemes do.

Real money has intrinsic value. Gold and silver are good examples of real money or honest money, terms to distinguish it from fraudulent money or bubble money, which is to say fiat currencies pretending to be money. Scotiabank estimates that the all-in average cost in 2013 for major mining companies to produce an ounce of gold is $1,690, or 35% above the current market price of $1,250 per ounce[20]. That is to say that if you buy gold today at $1,250, you instantly gain $440 of intrinsic wealth because gold cannot be produced at that price. Someone who sells it to you for that price is losing $440 of intrinsic wealth in the transaction. There are all kinds of reasons why an asset such as gold might be trading at below its intrinsic value, including excessive naked shorting of it. But all such undervalued assets always revert to their mean (and usually overshoot) in the long run. Gold doesn't only have value because the market says it does. It has intrinsic value (not only equal to the market value, but currently exceeding the market value), which is what makes gold a store of value and standard of deferred payments, and also currently just a good investment.

One day, perhaps very soon, there will be a run on fiat currencies as people flee to real money in order to preserve their purchasing power. The scope of promises made by governments and central banks -- approaching thousands of trillions of dollars -- versus the quantity of actual currency is an unimaginably enormous discrepancy, which once clear to the public at large, will blow away any "greater fool" illusions[21]. People will seek the safety of intrinsic value. When that happens, the demand for real money will explode, sending the market price of gold to multiples of its intrinsic value until mining companies (currently struggling to stay above water) are able to ramp up production to fill the demand. Prudent investors and prepared individuals will get ahead of this inevitable outcome by accumulating precious metals at currently undervalued levels.

Comments

Jan 17, 2014 7:08am

amethyst1478
Two methods I recommended to accumulate gold and silver bullion, both to preserve purchasing power and also to capitalize on the inevitable reversion to the mean, are Silver Saver (http://PassantGardant.com/SilverSaver) and Bullion Vault (http://PassantGardant.com/BullionVault). Silver Saver is a U.S.-based company which allows you to deposit small amounts of cash (Federal Reserve Note-denominated) into a silver-denominated account, allowing you to average in over time without making a single large silver purchase all at once. They also have gold available. Once you have enough to make a delivery feasible, you can have your bullion sent as various types of bars, coins, or rounds to keep in your own possession. Bullion Vault is a U.K.-based company which is both an international bullion vaulting system and also an online precious metals trading system. You can deposit your FRN (or Euro or Pound) cash into Bullion Vault and then use their trading system to enter into gold or silver positions or other currencies as you see fit. You can also use it to automatically average in over time. The main benefit of Bullion Vault is that your precious metals can be designated for storage in any of several jurisdictions including Zurich, London, Singapore, Toronto, and New York. As such, you can geographically diversify your holdings as a hedge against oppressive government actions toward your savings and investments in monetary commodities with intrinsic value.

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